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What Investors Need to Know About MLPs

What is an MLP? A master limited partnership is more accurately called a publicly traded partnership; it is a limited partnership or LLC taxed as a partnership. Its interests are called units and trade on the New York and American Stock Exchanges and NASDAQ, just like corporate stocks. An investor who buys units in an MLP becomes a limited partner.

What kinds of companies are MLPs? Because of constraints imposed by the tax code, most MLPs today are in energy-related businesses. There are also MLPs in coal and timber, as well as some in other industries.

Why are MLPs considered tax advantaged? Unlike corporations, MLPs and other partnerships are not considered separate entities for tax purposes. A partnership for tax purposes is referred to as a “pass-through” entity. No tax is paid at the partnership level. Partnership income is only taxed at one level, that of the individual partner. Since the MLP itself does not pay tax, it is able to pass along more of its earnings to investors than a corporation.

What does that mean for MLP investors? MLPs pass earnings on to investors via quarterly cash distributions, which are treated much more favorably than corporate dividends from a tax standpoint. Rather than taxable investment income, they are treated as a return of capital and reduce the partner’s basis in the partnership units. The partner is not taxed on distributions until the MLP units are sold and tax is paid on the gain, including distributions, or when the basis reaches zero. The partner does not have to pay tax on his or her share of partnership income, but since deductions such as depreciation are also passed through to individual partners, taxable income is usually quite low.

What happens when units are sold? The difference between the sale price and the adjusted basis equal the taxable gain or loss. Some tax on the capital gain from the sale will be taxed at the capital gains rate. The portion of the gain resulting from a downward adjustment of the basis after allocation of deprecation or other deductions will be taxed at the ordinary tax rate.

How can investors learn more about MLPs? Visit the website of the MLP trade association, the National Association of publicly traded partnerships at www.natptp.org. L —National Assocation of Publicly Traded Partnerships